The Chinese government maintains a very heavy hand in the market, as it recently helped fuel an equity market bubble, only to take aggressive measures to try to mitigate a subsequent slide. In addition, most listed Chinese companies are government-controlled firms, and at times, state interests can take precedence over profitability.
As such, investors may be concerned about a large exposure to Chinese stocks – and the news that index providers MSCI and FTSE Russell are considering adding China A-Shares to their respective global equity indices. China A-Shares are companies listed on the Shanghai or Shenzhen stock exchanges. Only recently have foreign investors been able to access these onshore-listed securities.
Most investors do not currently have exposure to the large, $3 trillion Shanghai and Shenzhen equity markets, as China has a mostly closed capital account, under which money cannot freely flow into and out of China. However, the door is starting to open.
Over the past few years, China has implemented a number of initiatives to allow for controlled foreign fund flows into its onshore equity markets, as part of its goal to gradually liberalise its economy. Index providers MSCI and FTSE Russell are monitoring these efforts and currently have Shanghai- and Shenzhen-listed stocks, also known as China A-Shares, on a watch list for inclusion in their respective global equity indexes.
The addition of China A-Shares would have little effect on global and international equity indexes, as China accounts for a very small percentage in these benchmarks. However, adding China A-Shares would have a significant impact on emerging-markets indexes – MSCI Emerging Markets Index, the FTSE Emerging Index, and the mutual funds and exchange-traded funds that track these indexes.
China is already the largest country allocation, accounting for 25%-30%, via Hong Kong-listed Chinese stocks, in each of these two indices, so the addition of China A-Shares would result in a larger China weighting. MSCI and FTSE Russell plan to add China A-Shares in a gradual fashion, where China A-Shares would initially account for a single-digit percentage of their respective emerging-markets indexes.
Over the long term, as China continues to open access to its markets, the total China allocation combining China A-Shares and Hong Kong listings could account for about half of a market cap-weighted emerging markets index. Investors who use emerging-markets index funds should consider if they want a potentially very large exposure to Chinese equities within their fund.
Why Should You Be Concerned About China A Shares?
Almost all of China's large- and mid-cap investable companies are the products of China's "state capitalist" economy. State capitalism is an economic system in which the state acts as the dominant economic player and uses markets primarily for political gain.
During the past few decades, the Chinese government has cultivated national champions and then sold off minority stakes to investors both inside and outside of China. Oftentimes, state goals – such as economic growth or low unemployment – can trump the interests of minority shareholders.
Notably, Chinese companies' dividend pay-out ratios are among the lowest within the emerging markets, despite the fact that many Chinese firms had been very profitable during the boom years. These companies have instead hoarded cash or invested in large capital projects.
Recently, the returns on these large projects have declined as China approaches the limits of its capital-intensive economic growth model. In addition to interfering at the company level, the Chinese government also maintains a heavy hand over the onshore equity market.
Which ETFs Will Be Affected?
The MSCI Emerging Markets Index is the most popular emerging markets benchmark. As such, a decision to include China A-Shares would drive significant flows into the onshore China market. Index funds and ETFs that track this index would likely add China A-Shares to their portfolios in tandem with MSCI.
Actively-managed emerging markets funds may not immediately follow MSCI's decision to add China A Shares. But portfolio managers who focus on minimizing tracking error will likely add China A-Shares soon after they are added to the benchmarks. Over the long term, China A-Shares may be increasingly viewed as part of the global equity investment universe. If this were to happen, global, international, and emerging markets equity portfolio managers may begin investing in China A-Shares.
